Mortgage Professor: A plan to jump-start housing

Policy proposals for dealing with our current depressed economy are largely at an impasse. Monetary policy has gone about as far as it can go, while fiscal policy is hamstrung by political constraints on any measures that enlarge the federal debt. Housing policy, in contrast, has enormous expansionary potential that can be released merely by revising or eliminating some of the many unproductive rules governing how home loans are granted.

These rules originate from Fannie Mae, Freddie Mac and in some cases from the Federal Housing Administration. In combination, these agencies touch about 95 percent of all home loans being written today.

Most of the rules apply to who is and who isn't qualified to borrow, and among those qualified, to how much extra they have to pay for deviations from pristine status. Liberalized rule changes would reduce expected losses to the agencies because the additional housing demand that resulted from them would stabilize home prices.

• Housing policy has been procyclical

The backdrop of these proposals is the procyclical federal housing policy that emerged over this decade. The government intensified the unsustainable boom during the go-go years of 2002-2007, and since the bubble burst it has aggravated the contraction. This was inadvertent, of course. The measures that have aggravated the contraction were designed to curb the abuses of the boom period, but they did not materialize until after the financial crisis, or just in time to make an already bad situation worse.

The housing sector has generally been a source of strength during recessions, but not during the current recession. The major reason is that in prior recessions, interest-rate declines stimulated the housing sector; but in the current recession, lower rates have been nullified by tougher rules on who can borrow. Many of these rules are new, but some are old ones that have become counterproductive in the current environment.

Expecting the federal government to run a countercyclical housing policy -- becoming more restrictive when private markets are euphoric, and more liberal when private markets are depressed -- is probably expecting too much. Government officials and legislators live in the same world as private lenders and are subject to the same influences on their expectations. But federal housing policy should at least be neutral, meaning that policy makers should not respond to cyclical changes in markets. The proposals contained in this set of articles would shift federal policy at least part of the way back toward neutrality.

Since the crisis, Fannie and Freddie have been working at cross purposes to the Federal Reserve. The Fed has countered economic weakness by forcing down long-term interest rates, including mortgage rates, to all-time lows. But Fannie and Freddie have made it increasingly difficult for potential borrowers to qualify, and cut the number who qualify for the very best rates to a trickle.

To get the lowest rate possible on a loan directed to the agencies, a borrower must have a loan-to-property-value ratio of no more than 60 percent and a credit score no less than 700. The property must be single-family but not manufactured, occupied as a permanent residence by the borrower, and in an area not subject to an "adverse market delivery charge." The mortgage cannot have an interest-only provision, and any second mortgage has to be included in the 60 percent limit.

Millions of refinance transactions that would increase the spending power of homeowners, which would have been funded in prior recessions, are not getting funded today. Either the borrowers no longer qualify, or they don't qualify for rates low enough to help them.

Two strategically important groups have been particularly hard hit. One is the self-employed, predominantly small-business owners who are a major potential source of employment growth. The other: investors who buy homes to resell at a profit, and who are desperately needed right now to buy foreclosed homes sold by lenders. Specific proposals related to these groups are discussed later.

• Conservatorship requires liberalization

Since September 2008, Fannie and Freddie have been in conservatorship.

The Federal Housing Finance Agency as conservator is charged with the responsibility of preserving their assets. FHFA has to sign off on any major policy changes affecting Fannie/Freddie.

In the current economic environment, a liberalization of Fannie/Freddie lending terms is a requirement of responsible conservatorship. According to Laurie Goodman, whose analysis of the current housing crisis is the most complete and insightful one I have read, believes if government policy does not change, 1 in 5 mortgage borrowers will lose their homes and a second round of home-price declines becomes highly likely. Agency losses will mount as a result.

The tightening of lending terms by Fannie/Freddie in response to the crisis has been very similar to that of private lenders making loans to retain. The difference is that no private lender can materially affect the market, but Fannie/Freddie can.